Why everyone’s talking about Spanish bonds

Spanish and Italian government bonds have been on a tear in recent sessions as investors become enamored of an enticing mix of low inflation and economic improvement in the euro zone’s struggling nations.

As investors buy into the debt, the yield on 10-year Spanish government bonds
/quotes/zigman/15866444/realtimeBX:TMBMKES-10Y closed below 4% on Thursday for the first time in three-and-a-half years, and dropped further on Friday to 3.895%, according to Tradeweb. Italian 10-year government bond
/quotes/zigman/4869096/delayedIT:10YR_ITA yields also dropped to 3.926%, with the spread to bunds similarly plunging below 200 basis points. Yields fall as prices rise.

“It’s been kind of a one-way trade. In this environment for fixed-income investors, how do you juice returns? You’ve got to get yield,” said Jack McIntyre, portfolio management and senior research analyst with Brandywine Global Investment Management, which owns Italian bonds.

The premium, or spread, that Spanish bonds pay compared to haven 10-year German bunds
/quotes/zigman/15866409/realtimeBX:TMBMKDE-10Y dropped below 200 basis points on Friday for the first time since April 2011 (see chart above). Likewise, the premium over comparable U.S. Treasurys
/quotes/zigman/4868283/delayed10_YEAR was less than 100 basis points, indicating that investors are demanding less compensation for the risk of owning Spanish bonds.

Another important part of the story is the disinflationary pressure in Spain and Italy. Year-over-year consumer price index growth, one measure of inflation, was most recently at a benign 0.2% for Spain and 0.6% for Italy. Adjusting for inflation, so-called real yields look more attractive compared to other bonds.

“What we do is look at real yields as a measure of value. Strictly based on that, the real yields are still high. From that standpoint they are still attractive,” said McIntyre.

Nonetheless, some market participants are skeptical, especially as spreads to German and U.S. government bonds continue to narrow.

“We certainly get people recommending Spain and Italy vs other things based on the real interest rate but does less than 100 basis points compel you to buy Spain vs. the US? Likewise vs. Italy?” asked David Ader, head of government bond strategy at CRT Capital Group LLC, in a note.

McIntyre notes that trading has been thin in government bond markets due to the holiday season. Thus, we probably won’t know how much more steam is left in this rally until the market gets back into full swing.

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